More on liquidity, solvency (and elitism) during the Great Depression

The rediscount of bank assets not now eligible in the Federal Reserve System in order to assure the stability of banks throughout the country from attack by unreasoning depositors. That is to prevent bank failures.

–Herbert Hoover, 1931 Letter to George L. Harrison, President of the Federal Reserve Bank of New York

I was thinking about the parallels between the Great Depression and today and looking back on the posts on Credit Writedowns tagged with “Herbert Hoover”, when I came across the quote above.

RT’s @LaurenLyster had asked me “so do you think the EZ is just a good excuse for US politicians to blame a double dip on or legit?”. I replied saying “I think the EZ makes a double dip worse but it’s an excuse for the US, yes. Hoover did it too http://bit.ly/s5QOC1”, pointing to comments Hoover and Obama both made blaming Europe for a potential Depression.

As I said last night, we are in a degenerating vicious cycle. Economic events of Europe have demoralized our farm produce and security prices. This has given rise to an unsettlement of public mind. There have been in some localities foolish alarm over the stability of our credit structure and considerable withdrawals of currency. In consequence bankers in many other parts of the country in fear of the possibility of such unreasoning demands of depositors have deemed it necessary to place their assets in such liquid form as to enable them to meet drains and runs. To do this they sell securities and restrict credit.

Hoover had the mechanics of bank runs and debt deflation right, didn’t he. The problem is he had the diagnosis all wrong. Harrison sets him straight in reply:

…In this district, where I happen to be more familiar with the situation than in other sections of the country, the principal cause of bank failures has not been a lack of liquidity but rather insolvency caused by need for a drastic write-off in bond portfolios. In other districts, I understand, many banks are threatened with insolvency because of losses in real estate loans as well as bonds.

So, while the proposed corporation will do much promptly to provide liquidity for certain solvent institutions needing cash, thus avoiding the forced sale of their assets at substantially depreciated values, it will not unfortunately be able to aid materially in improving the banking situation in those districts where the principal difficulty is the threat of insolvency through depreciation of bond or real estate values.

I hope that sounds familiar because it is very much the situation European banks are facing right now and that American banks faced in 2008 and 2009 (and will face again in another recession). Liquidity crises are always solvency crises. The question is about determining which company, nation, or debtor is insolvent in a world of incomplete information. This leads to panic and a wider liquidity crisis that stresses the balance sheets of everyone, including the insolvent debtors. Indeed, the insolvent almost always are shaken out and bankrupted by this process (or are bailed out by government). The problem is that the shake out process kills a lot of other companies too.

This is what debt deflation is all about.

However, Hoover’s comments troubled me. When he speaks of “unreasoning depositors”, “foolish alarm” and “unreasoning demands of depositors”, it’s clear he doesn’t get it. More than that, his comments go to an elitism that permeates the thinking of insiders. In effect, Hoover is saying “we who govern are smarter than you who we represent”. He is saying “you citizens are ignorant about how our financial system works and creating a disaster as a result.”

Harrison is telling Hoover, “no, we who govern are not smarter at all. You are the one who doesn’t understand our financial system. The banks are insolvent. The people are justified in worrying about the safety of their money.”

I side with my namesake on this one.

Peter Orszag, formerly of the Obama Administration and now at Citi, gave voice to this kind of elitism recently. He wrote in the New Republic:

…To solve the serious problems facing our country, we need to minimize the harm from legislative inertia by relying more on automatic policies and depoliticized commissions for certain policy decisions. In other words, radical as it sounds, we need to counter the gridlock of our political institutions by making them a bit less democratic.

Got it. “We who govern are smarter.” Hoover’s and Orszag’s comments belie an elitism that makes many ordinary citizens recoil in revulsion. It is the sense that precisely this elitism is what underlies the cronyism that has allowed banks and favoured corporations to be bailed out while ordinary people lose their jobs, homes and dreams which has given rise to protest movements like the Tea Party and Occupy Wall Street. Remember, it is the elites who crashed the economy and have yet to figure a way out. Why should we think they know better?

In the U.S., we have faced this kind of crisis of elitism before during the days of Andrew Jackson. Wikipedia does a good job contrasting the different ideas about democracy in the fledging American Republic. Here’s a quote from the entry on Jacksonian democracy:

Jacksonian democracy is the political movement toward greater democracy for the common man typified by American politician Andrew Jackson and his supporters. Jackson’s policies followed the era of Jeffersonian democracy which dominated the previous political era…

[…]

In contrast to the Jeffersonian era, Jacksonian democracy promoted the strength of the presidency and executive branch at the expense of Congress, while also seeking to broaden the public’s participation in government. They demanded elected (not appointed) judges and rewrote many state constitutions to reflect the new values. In national terms the Jacksonians favored geographical expansion, justifying it in terms of Manifest Destiny. There was usually a consensus among both Jacksonians and Whigs that battles over slavery should be avoided. The Jacksonian Era lasted roughly from Jackson’s 1828 election until the slavery issue became dominant after 1850 and the American Civil War dramatically reshaped American politics as the Third Party System emerged.

Here’s what Wikipedia says about Jeffersonian democracy:

The Jeffersonians believed in democracy and equality of political opportunity (for male citizens), with a priority for the "yeoman farmer" and the "plain folk". They were antagonistic to the supposed aristocratic elitism of merchants and manufacturers, distrusted factory workers, and were on the watch for supporters of the dreaded British system of government. Above all, the Jeffersonians were devoted to the principles of Republicanism, especially civic duty and opposition to privilege, aristocracy and corruption…

[…]

The Jeffersonians advocated a narrow interpretation of the Constitution’s Article I provisions granting powers to the federal government. They strenuously opposed the Federalist Party, led by Treasury Secretary Alexander Hamilton. President George Washington, generally supported Hamilton’s program for a financially strong national government. The election of Jefferson in 1800 –Jefferson called it the "Revolution of 1800"– brought in the Presidency of Thomas Jefferson and the permanent eclipse of the Federalists, apart from the Supreme Court…

[…]

The core political value of America is republicanism; citizens have a civic duty to aid the state and resist corruption, especially monarchism and aristocracy.

That’s all I have to say.

Either side of this argument can point to valid concerns underpinning their world view. Ultimately, however, Jacksonian versus Jeffersonian democracy is a philosophical or political question which becomes much more relevant in times of economic or military distress like now. I am probably mostly on the Jefferson side.

P.S. – this post on democracy is not an argument for or against what George Papandreou has done in calling for a referendum in Greece. In general I agree with @PragCapitalist (Cullen Roche)’s arguments on Twitter about the benefits of representative democracy over direct democracy. No one wants tyranny of the majority. I would make that argument very differently, however.

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty five years of business experience. He has also been a regular economic and financial commentator in print and on television for the past decade. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College.

Agree with that 100%. The FDIC gives bank managers perverse incentives because of its safety net but it also prevents bank runs.

fresno dan says 7 years ago

Insightful analysis as usual.
Being a dinosaur, and getting my moniker from Fresno, I actually know about this:
In mid-September 1958, Bank of America (BofA) launched its pioneering BankAmericard credit card program in Fresno, California, with an initial mailing of 60,000 unsolicited credit cards.

How much is something worth if the funds available are:
A. The amount of money you actually have
OR
B. The amount of money an idiotic and/or criminal banker has lent you knowing that if you don’t pay, the Fed will?

I think your point:
“The question is about determining which company, nation, or debtor is insolvent in a world of incomplete information.”

is very insightful. But I would ask a question:
why is it that we have things like Basil, the machinations of the Fed, and finance laws taking something that is pretty simple (loans get paid back except for defaults) and making it (loaning money) and more and more and more complicated?

I don’t know. But I would suggest that people at the top want to keep the chimera of “profit and LOSS” without the loss, so they can keep the rationale of high compensation for all the “RISK” they take – OW!!! (I hurt myself laughing – how many people at the top of finance are now poor?). I must have been taking a nap when the world changed and losses for the wealthy were outlawed.

But if the value of anything and everything is only supported by “borrowed” and levered money, than the whole edifice comes down when there is a margin call anywhere…

Max Shifrin says 7 years ago

Actually I tend to agree with the argument that those who are elected to represent the masses are smarter. The ruler has to be on average smarter than the average Joe and usually is, otherwise why would he/she be elected to rule? (lets ignore lobying and such for a minute and assume that even lobbying doesn’t put complete iddiots at power most of the time)

Panic is much harder to rule then a calm public mood and that’s where I tend to agree with Hoover arguments that panic causes more damage then no panic, even when panic is justified.

Max Shifrin says 7 years ago

Actually I tend to agree with the argument that those who are elected to represent the masses are smarter. The ruler has to be on average smarter than the average Joe and usually is, otherwise why would he/she be elected to rule? (lets ignore lobying and such for a minute and assume that even lobbying doesn’t put complete iddiots at power most of the time)

Panic is much harder to rule then a calm public mood and that’s where I tend to agree with Hoover arguments that panic causes more damage then no panic, even when panic is justified.